Flows before pros?

Flows before pros?

A recent Barron’s interview with James Montier got me thinking. In it, the GMO man answers a question about lofty valuations across both bonds and stocks that have caused consternation for asset allocators seeking good value in the market. In response, he says: “The US market is at its second or third most expensive point in history. So people are saying, ‘I either don’t understand the world anymore, or I don’t think that valuation matters anymore.'”

I think he has a point but maybe not the one he means. Valuations do matter because in a world of inflated asset prices but suppressed actual price inflation or economic growth, they’ve become the easiest and most surefire way for investors to generate outperformance, and so, that is what they are chasing. I still think Citigroup’s Matt King put it best, when he argued two years ago that something fundamental had changed in the market’s behaviour.

The crux of this argument is that markets used to be self-limiting. Prices of securities would move up to a point where their yields would become unattractive, at which time investors would trim some of their positions, causing prices to go down and yields to recover. Now the intense search for returns has altered that dynamic, with investors chasing inflows as a means of getting higher prices and higher profits.

While the notion that  value investing is disappearing in a market that has moved ever upward for the past five years is not exactly new, King’s presentation here is stark. Investors have been moving in tandem, he says, making markets far more homogenous. The chart below shows investor positioning in credit markets, where the number of longs has vastly outnumbered the shorts, along with the International Monetary Fund’s herding metric. In short, investors across a number of asset classes are going mooo as one-way positioning dominates…

We often say the market can stay irrational longer than you can stay solvent. Maybe the updated version should be that the market can self-perpetuate for longer than expected.

One thought on “Flows before pros?

  1. It’s end December now and the wheels are coming off. When I see markets as they were up until a few weeks ago I always think. ” the more things change the more they stay the same” .Back in the Autumn I wrote to a professional investor friend and said I really couldn’t believe how many furiously waved red flags were being ignored .
    For what it’s worth I agree entirely that market participants had come to think that as James Montier wrote valuation didn’t matter any more. I’ll take a little credit for building cash and shorts positions during that period but I have to admit I owe a great debt to Charles Mackay the author of Extraordinary Popular Delusions and the Madness of Crowds.
    Reading almost any chapter of this wonderful book never failed to reinforce my belief that something akin to the current collapse was inevitable and probably imminent.

    Thanks for your always interesting pieces.

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